Mechanics of an Overseas Trade

Study Notes:

In this lesson we will explain the complexities of trading stocks in a currency other than your base account unit. In particular we will show you the various outcomes when buying stock using a Portfolio Margin loan and the price of the shares rises or falls in combination with a shift in the value of the borrowed currency. And we will also work through the same iterations when the investor manages the exchange rate risk rather than borrowing on margin.

At the outset then, there are several identifiable risks and considerations facing investors wanting to buy shares abroad. As with domestic investments, buying and selling shares in overseas companies contains trading risks. And of course there is also exchange rate risk, which could impact P/L adversely or positively. In fact as you will learn later in this video, currency movements can wipe out gains on the underlying investment. Because we are discussing overseas trades, there is an associated settlement concern, which may simply create additional problems due to holidays in the country where the trade settles. Investors may need additional market data subscriptions especially if they want live market data for stocks which they are holding or even monitoring.

Because IBKR connects to more than 100 global market venues and offers clients a base account in more than 20 foreign currencies, it has sophisticated monitoring software. What we are about to illustrate in this video revolves around a critical piece of software known as the IB Credit Manager. This apparatus automatically checks the status of a client’s account at the point of trade entry. And depending on the account status, Credit Manager makes a set of logical decisions.

When the Client enters a foreign stock transaction, Credit Manager checks the associated currency account for availability:

• If foreign currency is available – Credit Manager permits the stock trade and debits the currency account
• If foreign currency is NOT available – Credit Manager creates a Margin Loan using base currency as
  collateral and THEN permits the transaction.

Note Margin Loan is only for Margin accounts – loans are not permitted in Cash accounts

Alternatively: The client may BUY currency ahead of time in which the foreign stock will settle. The bought currency will appear in the Account Management window as a Cash credit.

Or the Client may attach an FX order to the stock transaction when creating the order. If the parent stock order begins to fill, the FX child order will start to fill.

We will look now at the case of a US investor buying shares trading in a British company on the London Stock Exchange. We will examine three cases starting with what happens when the investor converts currency as shares are bought. Later, we will look at two cases when using a margin loan and finally, try to draw some conclusions. Each scenario begins with the following assumptions.

A US investor has a $15,000 account and wants to buy shares in ABC Corp. in London trading at £1.00 each. At the outset, the current rate of exchange means that the British pound buys $1.50. It’s unimportant that investor has greater buying power, but you should understand that the sterling equivalent value of the account is £10,000 at that starting exchange rate.

Currency Conversion – Case 1

• Investor SELLS $15,000 and buys pounds at the exchange rate of Stg/$1.50. The account now has
  Stg10,000 and can buy 10,000 shares at Stg1.00 each
• Over a few months, the share price has not moved, but the pound has weakened, buying fewer dollars –
  Stg/$= 1.40.
• Liquidating shares at Stg1.00 each and exchanging Stg10,000 at the rate of $1.40 yields $14,000 for a
  $1,000 loss.

Currency Conversion – Case 2

In the second case, this time the pound strengthens relative to the dollar. One pound now buys $1.60. Multiplying Stg10,000 by the exchange rate now means the investor has $1,000 gain when returning his cash to dollars.

Currency Conversion – Case 3

Now let’s assume Shares rise by 10% so that the investor has a Stg1,000 capital gain. On screen displays the impact of that capital gain on the stock when the dollar gains, remains the same and declines versus the pound.

And if shares fall 10%, the investor has a Stg1,000 capital loss. On screen displays the impact of that capital loss from the stock when the dollar gains, remains the same and declines versus the pound Let’s turn now to some iterations when a margin loan is used to fund the share purchase abroad. In practical terms, at the point of the share transaction, the cash account in the settlement currency (in this case British pounds) is zero. The Credit Manager software automatically creates a margin loan
recognizing that the sterling account is in deficit to the value of the bought shares.

Margin loan

When the investor buys 10,000 shares, Credit Manager deals a Stg10,000 margin loan secured against the US$ collateral in the investor’s account. No matter what happens, the investor has to repay that loan after the shares are sold. If the share price falls, there will be a shortfall. If the share price rises, there will be a surplus in the British pound account.

Case 1 –

The Share price rises 10% – the loan is repaid but leaves a Stg1,000 gain – on display you can see the impact of the dollar rising, staying the same and falling on the value of that capital gain when it is exchanged back into US dollars.

Case 2 –

Shares fall by 10% – the loan repayment falls short by Stg1,000 after the price decline – the display illustrates the impact of the shortfall when the dollar rises, stays the same and falls on that margin loan shortfall of Stg1,000.

Pros and Cons

• With the Currency Conversion
• The investor faces currency risk on the principal sum
• There may be daily P&L impact due to currency risks
• But there are no finance charges

Margin Loan

• Currency risk is removed from the principal sum
• Capital loss on equity may create a debt of greater value than the original size of the loan
• There may be daily P&L subject to currency risk
• There may be finance charges depending on the yield spread between the base and overseas currency
• Base deposit accrues interest
• Margin loan incurs interest

These are the Mechanics of an Overseas Stock Transaction and you should be able to see the risks between margin loan and currency conversion. In our next lesson, we demonstrate how to create both types of trade using TWS.

In summary: Currency movements will affect P&L when performing transactions using non-base currency units. The investor needs to consider the benefits or drawbacks of managing currency risk or taking out a margin loan.

Before you attempt to place overseas trades, make sure that you understand the process and understand how order attachments work in TWS.